The Taxation of Small Business: Pass-Through Entities

Americans have always been very entrepreneurial—a majority of Americans will start a business at some point during their career, and there are many important legal as well as cultural advantages that set America apart from the rest of the world when it comes to business formation.[1]  In most jurisdictions and in most professions it is quite easy to set up a business and the American culture lionizes the small businessman, two things that are not at all common elsewhere in the world.[2] 

So it is hardly surprising that a large number of individual tax returns each year report that some portion of their income comes from owning, operating, or participating in a business.  In 2009, nearly 23 million returns reported some amount of business income.^[3]  The tax code does not tax sole-proprietorships, partnerships, or S-corporations as businesses.  Instead the income is “passed through” to the individual’s tax return to be taxed; thus these entities are referred to as “pass-through” entities.  These pass-through entities play an outsized role in the U.S. economy. Together, these three types of entities reported revenue of nearly $13 trillion in 2008, 86% of our $15 trillion economy.[4]

However, the current tax rates affecting these small businesses are set to increase in 2013 unless Congress and the administration act to extend the so-called “Bush tax cuts” of 2001 and 2003 for another year. The expiration of these tax rates would not only increase the tax bills for millions of Americans but it will also cause taxes to go up on millions of small businesses.   In the short term, the tax increase threatens the already-tepid economic expansion of the past three years.  Over the longer term, the higher marginal rates depress job growth and investment in small businesses. 

We estimate that the impact of raising the top two tax rates would be severe, with output falling by roughly the current rate of economic growth, and the unemployment rate jumping to nine percent.  Over the longer term there would be permanently impaired incentives for small businesses to hire and invest.